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Why Oil Prices Will Rise And Many Pundits Will Be Caught By Surprise

I follow oil pretty closely given our exposure. As such, I get frustrated with many press and news show accounts of the commodity. It gets worse when the pundits and writers should know better. Frequently inexact terminology leads to misconceptions and sometimes I see outright falsehoods that completely distort the truth.

As a former oil analyst and professional energy investor, I feel compelled to take those to task. As a realist, I see that all markets require a difference of opinion and all investors talk their “book”. For this reason, when Jeff Currie at Goldman Sachs Commodities Group gets on CNBC and opines about future price movements, I give little notice. Jeff is posturing for his customers' and GSs' positions. Jeff can spin the story either way and chooses his statistics accordingly...That's what he is paid very well to do.

Last week (March 28, 2016), I heard Dennis Gartman of the Gartman Letter, a trader and investor that I respect and have learned much from, spout an outright falsehood on CNBC. Everyone can have a bad day, but I’ve been hearing various versions of this for months. Dennis said in essence that oil prices could not rise very much because of "all the capped wells that could be brought on line very rapidly". He predicted no more than $42/bbl this year. He estimated that at current strip pricing, you could lock in $45/bbl in 12 months, making large numbers of these "capped" wells profitable. The implication being that at current prices, the market would be rapidly flooded with new oil.

I'll take the over on price, the under on production and bet all my capital that I'm right. (Oh, I already did that...). Dennis should know better. For fun though, I thought I'd like to take apart his thesis.

First, there are no “capped” wells in the U.S. To my knowledge not one well has been capped due to low prices, especially relatively young horizontal shale wells. Older wells are capped all the time when production is no longer sufficient to pay operating expenses for the well. Generally, onshore wells may cost something in the order of only $2,000 per month to operate. At $40 dollar oil, 3 barrels per day of production (gross) should cover operating costs. Related:$120 Oil As Soon As 2018?

What Dennis is likely referring to is the “Drilled Uncompleted” or DUC well inventory in the various shale plays. Some estimates have shown as many as 4,000 of these DUCs exist and the numbers are rising. Many pundits cite these DUCs as an effective ceiling on oil prices.

However, a DUC is very different from Gartman’s implied “capped” well. There are many reasons why a producer would drill and not complete a well. They may have had a rig under contract, they may want to beat competitors, retain their or their service companies’ good employees, they may be able to hold expiring acreage, they may just want to see what the rocks look like in a particular area. However, the most likely reason is that the completion costs of these wells can amount to over 60 percent of well cost maybe – $3 to $4 million per well. As such, this investment is very difficult to recoup if a well’s flush initial production is sold at low prices. This is compounded when whole well pads are completed at the same time to increase efficiency. If you don’t like the price one well gets, six wells coming on line at the same time is worse.

This also flows into the other reasons why this production will not flood the market, namely the intersection of costs, timing and decline rates.

• Costs – 4,000 wells at even $3 million per well is $12 billion dollars. Given the upheaval among producers, where does Dennis suppose the $12 billion will come from to “instantly” “uncap” these wells and increase production? Not from the banks, the high yield market is tight, equity investors have stepped up for some Permian and Eagle Ford producers, but $12 billion is a lot of money.

• Time – Let’s say that oil prices above $40/bbl equals a green light for energy producers to attack their DUCs. (There appears to be no factual basis for this, but let’s pretend.) A quick look at C&J energy services, which controls the country’s third largest frac fleet as well as other completion services, tells part of the story. Today, just over 50 percent of the companies’ fleet is working and the rest is “stacked” or to be retired. The people were laid off months ago. Clearly, when they get the signal that their customers want more completion services, they will begin to reactivate some of this idle iron – one frac fleet at a time. The problem is the C&Js stock price is $1.46 and they have close to $1.2 billion in debt. Where will the money come from to rehire people, and reactivate idle equipment? After that, will the people return? Yes, but slowly and at a high cost. What about Baker and Schlumberger? Both are in better financial shape but their fleets have been stacked also and at this time, investors are in no mood to hear a company talk about adding capacity. When these companies return fleets to active status, they will be competing to hire a smaller pool of laid off workers. Related: Unfolding The World’s Biggest Oil Bribery Scandal

• Decline rates – Wells producing from tight rock or shale (wells that must be fracked) exhibit steep decline curves on the order of 75 percent during the first year of production. The implication is that producers are on a never ending treadmill in order to maintain or grow production volumes. That is, they must complete new wells in order replace the natural declines from existing wells. There are two critical points associated with these steep decline curves that pundits like Gartman don’t appear to grasp. The first is that based on current data, the four key liquids rich shale plays have declined by over 600,000 bopd since their peak of production in March, 2015. This production is gone. These wells have depleted. They can’t be turned back on. The only way to increase production again is new completions and new wells – in other words massive new reinvestment. This is very different from past cycles when OPEC dialed back production by idling a major field or two until demand rebounded. These OPEC giant and super giant fields are a totally different animal. It’s all about the infrastructure, not the productivity of a single well. The entire complex can be shut down, reworked, maintenance performed, etc. then turned back on…more akin to a refinery than typical single or multiple well fields. But that’s another story. Bottom line – that 600,000 bopd is not magically coming back. It took the onshore industry something like 12 months running flat out to add those volumes. Given oil prices, it will be quite a while and it will take higher prices before the industry even gets back to a steady walk, much less a flat run.

Another key thing to understand about decline curves is that they are continuous and right now declines are accelerating. However for example purposes, let’s look at the Eagle Ford. There are some 10,000 wells in the Eagle Ford producing today, and they are all in decline. The EIA estimates the average Eagle Ford well adds 800 bopd in its first month of production. Last month, Eagle Ford production is estimated to have declined by 60,000 bopd. That implies that 75 new wells per month must be drilled and completed to just replace this 60,000 bopd. Assuming it takes 15 days to drill a well, that implies around 38 rigs drilling and around 25 frac fleets running above what is running today! Today, there are 42 rigs drilling for oil and we estimate 10 – 15 frac fleets running in the Eagle Ford…so just to replace production, the industry would have to increase rigs running by nearly 100 percent and frac fleets by 150 – 200 percent. This would require a massive mobilization of capital and manpower. During this whole mobilization process, production from existing wells is declining, month after month. Don’t get me wrong, I believe this will happen. However, I know this won’t happen quickly and won’t happen at $40/bbl oil, making Gartman’s thesis and pricing argument completely false.

Production data, or lack thereof, is a primary hindrance to clear and transparent oil fundamentals. The mechanics of the above discussion would be more obvious if we could measure field production in real time. In fact, production data in Texas takes some three months to even estimate, and these estimates are often revised. The same goes for well completion data. The EIA tries to model this through its “Drilling Productivity Report”. However, there are no similar efforts for the rest of the global oil industry, in fact, OPEC publications use third party reporting not internal or “real” data from the companies themselves. Related: Advantage U.S. In The Global Petroleum Showdown?

In Saudi Arabia, production statistics are a state secret. Not surprisingly, many countries distort the data to suit their own needs. That’s why the IEAs look at G7 storage data is an important industry statistic. It is widely recognized that both global demand and supply data is inaccurate, but changes in storage inventories should reflect supply and demand changes. The only problem with this approach is they only get data for around 2/3 of the global storage capacity. This is what led to the recent headlines “800,000 bopd of oil is missing”. Supply estimates exceeded demand estimates by 800,000 bopd during the quarter, yet storage didn’t build, leaving the question of where did the oil go? The answer is that there never was this extra oil…if it existed, it was burned. More than likely, both supply and demand estimates were off by that amount.

Third parties like "Drilling Info", BTU Analytics, CERA, etc. provide their looks at the market for very high prices, and as such are much more granular than those from government data providers. As much as they try, they are still limited by the availability of international data and reporting time lags domestically, not to mention their own biases.

Generally it takes 18 months before the world has a decent picture of supply and demand. This is little consolation to those trying to do real time analysis on the direction of prices. That is why I can say categorically “the fix is in”. In other words, fields are declining, meaning investment is far below levels required just to replace production. The only thing that will change the vector of these declines is more spending, lots more spending, and the only thing will spur lots more spending is higher prices. Significantly higher than $40/bbl.

In conclusion, we have a typical commodity price cycle. Prices have dropped to levels destroying capital, bankrupting businesses, idling massive amounts of equipment and manpower. The cycle is reversing now. The weekly EIA numbers are showing steady declines in production (this is a balancing item – not real production estimates) and also increasing demand – In the United States. The IEA is showing the same thing in their monthly report that has a decent look at the G7 countries and attempts to look at the G20. Between these two, there is a large world with little accurate measurement. China for instance jailed a Platts reporter for espionage when he tried to put together a fundamental energy statistics database.

Inevitably, we will have another price shock – or at minimum an upside surprise. It’s unavoidable at this point. Oil never transitions smoothly. Just like all the oil bulls had to be run out during the declining price stage, all the price bears, like Dennis Gartman, will be run out when fundamentals hit them over the head. Gartman, to his credit, will change his tune 180 degrees when he sees the actual data shaping up. That’s how he has survived so long and profitably as a trader.

But by then it will be too late, the world will want incremental supplies immediately – yet the industry cannot scale in real time. In order to motivate producers to get busy and provide incremental supplies, prices must increase sharply from current levels. My prediction - $80/bbl in 18 months, but it won’t last very long. I think $60 - $70/bbl is a healthy range.

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LOL! Excess supply until its all gone and sick gloabl econs.
Perleeeeeze.

Corey on April 05 2016 said:

Great article. Sat on cash and low risk investments all my life. Switched to all small cap Canadian oil stocks at end of jan Figure it's a once in 20 year play. If you are right I'm a hero if not my retirement plan is death

Sung on April 05 2016 said:

I don't have a view on the direction of the oil personally, but this article offers the author's view that is based on factual data. A pleasure to read such well reasoned article.

Roland on April 05 2016 said:

The only possible error I find is in "Decline Rates." Fracked wells that have declined can be refracked, in fact they may produce more, "Second time's the charm":
http://www.bloomberg.com/news/articles/2015-07-06/refracking-fever-sweeps-across-shale-industry-after-oil-collapse or search for "refrack".
But again, with completion companies beset, that will require time & cash.

FOSL on April 05 2016 said:

Very well written article sir!!! We share the same vision and observation. Accurate measurement of our oil industry is a waste unless 100% can be calculated world wide. The world doesn't know there is too much oil until its too late and today we don't realize we don't have enough because of lack of investment and that investment will not be easy to access from once bitten-twice shy bankers and private equity. Keep up the good research and writing!

nuffalready on April 05 2016 said:

Thank you Brad. You are the first pundit to cut thru the Gartman-esque BS out there. We've all been waiting for this article.

Yager on April 05 2016 said:

Outstanding!

zorro6204 on April 05 2016 said:

I thought the most hopeful stat in the last EIA report was that 50% of US production comes from wells less than two years old. Some of that is recent Gulf activity, and it won't decline as fast, but most of that is shale. While techniques such as choking may reduce the rate, shale still declines quickly. The only way to replace the decline on that 4.5-4.6M bpd of production is to drill like a rat in heat, and we're not. "Super wells" in "sweet spots" may help, but the Goldman thesis, aka "shale revolution II", is clearly not kicking in. They proposed that new technology would allow even marginal shale to break even as low as $20. Clearly we're not there.

Still, it's a long road up from the bottom, inventories are at peak levels, US production is still above 9M bpd (maybe it will crack that tomorrow), and even if US production fell by twice what the EIA estimates by the end of this year, Canada is going to be increasing production this year and next, and Iran alone might offset our decline. Who knows, maybe the maniacs in Libya might even stop shooting long enough to dump more oil on the markets.

All things taken together, I think your 18 month time frame is about right, and quite possibly an over-shoot to $80 could happen, for awhile. Of course, many US firms are not going to survive that long, but that's a necessary part of the bottoming process. You probably don't need to rush out and buy oil equities right now, but as the year progresses, there could be a generational buying opportunity.

Excel Royalty on April 05 2016 said:

Great article. Please explain why if there is a glut of US production we import 8MM bbls a day? I understand it is because shale mostly produces liquids that aren't marketible so we need imports to get the kind of oil we need. Is this correct? Are the volumes in storage not marketible? will the market adjust to this?

Marc Johnson on April 05 2016 said:

Great article. He said many of the same things I think every day when
I listen to the talking heads who clearly would not know a drilling rig from a work over unit. Somehow these people seem to think there is a simple on and off switch for oil production. I especially liked that he pointed out that the price transition will not be smooth. It never is. When the world figures out storage is being drained with near zero spare capacity available- then prices will rise radidly just like they fell rapidly. I look for $90 WTI by the end of 17.

Sheran King on April 05 2016 said:

A good read.

Million on April 06 2016 said:

Great analysis!
Frac'd wells that show sharp decline in their first yr...also continue to produce for about 20-30 yrs at lower rate...here optimization could help and still create values for companies..

Robert on April 06 2016 said:

Thank you for taking the time to share this knowledge and understanding with those of us less familiar. Not only did you take a position you provided the sound fundamental basis for it.

Paystone on April 06 2016 said:

Best article I have read in some time on supply demand critical issues.

DUCDUCGoose on April 06 2016 said:

From Whiting's recent Q4 earnings call:

James J. Volker - Chairman, President & Chief Executive Officer

Sure. Well, in terms of the drilled and completed wells in 2016, 10 in the Bakken, 16 in the Niobrara, to answer that question. To answer the second part of the question, yeah, probably if oil prices recover back into the $40 to $45 price range, then we would consider completing some of these wells.

Philip Branton on April 06 2016 said:

While this article is well written and pointed, this author needs to rethink just how informed his readers really are. The informational lag he notes on well productivity numbers is mis-leading. Does he dare wonder just how connected all the pipeline valves are across the country..? That data is easily ....."calculated"..! Kinda reminds me of the "Trading Places" movie and the orange grove commodity figures in a briefcase. ( https://www.youtube.com/watch?v=7EjdC0pjo1A )

This writer does know that a strategic Oil reserve has an informational hub.....does he not?

Time and info........may be seen "3" months ago.

Twitter was at an all time "low"......

Philip Branton on April 06 2016 said:

We wonder if anyone recognizes why this article has more comments than most..? Well, maybe they watch the Colbert show and understand the untapped Methane that is not being tapped that "possibly" holds huge OIL reserves too boot..!!

Just watch and ask why Colbert mentions the Methane craters in this news segment. How would oil rise or fall with the actual truth being known concerning the energy capacity off the eastern seaboard? "Leviathan" may not just be a field in the Med..

https://www.youtube.com/watch?v=faXLfQABEiQ

Can any pundit tell concerned investors how long ago certain info was known but never released from a Panama paper offshore "Texas tower"..?

avenger 426 on April 06 2016 said:

Funny stuff. The energy markets are changing thanks to big oils greed. High oil started the depression we are in. Low oil equals possible recovery. The is no scenario where high oil is good for the economy except for you over paid oil barrons. The energy markets have caught up to big oil. Companies are tired of being screwed by oil prices. Hybrid and electric cars are the future. Companies are figuring ways to make chemicals without oil and homes and appliances are getting more energy efficient daily. Solar power is plummeting in price. Oil won't go away, but you can bet oil exec's are looking hard at diversification.
Basic economics don't change with greed and corruption. It will be satisfing to watch oil plummet back to where it should be and watch oil exec heads roll. Oil is supposed to be a cheap commodity, not gold. If you are deeply invested in oil, enjoy watching your money shrink. You oil guys are the definition of greed and corruption. You have destroyed the world economy. Your day 8s coming.....soon.

Tommy on April 06 2016 said:

Interesting articles, the writer clearly knows what he's talking about

Brad Beago on April 06 2016 said:

Philip Branton, I'm having trouble following your logic...the oil market is global, perceptions of supply and demand globally moves prices. Specifically, perceptions of even minute changes to equation cause traders to move in one way or the other..Most recently dollar strength or weakness relative to global currencies has seemed to be the dominant driver short term. In the U.S. and in Canada also, we have substantial visibility and granularity in energy data - but its far from real-time. Not so in the rest of the world. Try to find out how much the Ghawar field - the largest oilfield inthe world, produced last month. How about last year? What's the water cut? Can you tell us what and how much oil and storage capacity exists in China?

We are left with a 95 million barrel per day market that we have real visibility on 1/3 to 2/3 of and to varying degrees at that. That's what makes a market...

Brad Beago on April 06 2016 said:

To Philip Branton - with regards to methane hydrates, its certainly interesting. The Japanese did some tests last year. However, if you havn't noticed the U.S. currently has more methane than we can either burn or export-so much so that we have stopped drilling ofr it in a number of basins..in maybe 25 years, we'll be looking for new, more expensive and untested hydrocarbon sources.

Mentor Depret on April 06 2016 said:

Finally an analysis with great insight! Of course I agree with the conclusion but I will not be surprised to see oil back above $100. It is all about speculation which always exaggerates in both directions. Once they smell a shortage, be sure the price will go stratospheric.

Darryl on April 07 2016 said:

I've been telling people for quite some time now that we are going to wake up one morning and say " oh my God, we don't have no oil or oh my God, we don't have no gas" and then the cycle just starts over again.

Andy O'Donovan on April 07 2016 said:

A good to read an article with depth and analysis, rather than soundbites. It would be interesting to extend the logic beyond US shale as the only potential control on the supply side going forward. Shale isn't exclusively US... what would be the impact on supply side of the equation as China and Russia start to access shale resource on the Asian landmass. These are countries where labour costs are substantially less and the strategic value of developing their own resource likely to overcome any investment hurdles or environmental concerns.

John on April 07 2016 said:

there is a problem with his reasoning. He is obviously under the assumption or simply unaware that there are new technologies to revitalize old wells that are no longer viable. The cost to do this is about 250,000 per well and can get it pumping up to 70% of its initial rates. This lowers the cost significantly to re-frack a well. Why do you think with investments falling off so much over the last year or more production is only down 600k per day? this is why. they have cut their capex in half and are still producing at nearly the same rate. Its going to be a lot longer to get oil back to $70 or $80 than what Brad Beago who wrote this article realizes. thats what happens when you put all your money (as he more or less stated at the beginning of the article) into oil when there have been a lot of changes and adaptations to the low prices being felt by these producers. You could end up on the short end of the stick.

kurt froehlich on April 07 2016 said:

Interesting. I was looking at the charts thinking of getting long. I was seeing a real possibility of Brent above 55 within the next one or two months. That upside surprise Brad is talking about looks very possible on my charts and a very big money winner given the really cheap call options. Wouldn't surprise me to see March highs challenged and taken out next week.

Abe on April 08 2016 said:

Excellent article mostly N America focused whose impact on prices obvious but the oil world is not about shale oil nor about N America. hope to write more on this later

Edward on April 08 2016 said:

Very well written and reasoned. Like others, I'm banking on his fundamental position coming to fruition.

$80 a barrel in 18 months will allow me to buy my children the GI Joe with the kung fu grip for Xmas (see Phillip Branton above).

Covkid on April 09 2016 said:

Brilliant article, I have also wondered why the 'experts' have not taken the above points into account, either they are incompetent or they have another agenda.
Firstly, every oil producing country (cleptocracy) needs an oil price of >60USD to balance their budgets. 2nd John above mentioned it has become cheaper to produce shale oil, it hasn't, it's just the service companies have dropped their prices. The shale oil companies are still pumping just to stay afloat, how many pay dividends - it's money down the drain (unless we see 100USD). As for the '2nd fracking'..... declines are still declines, I wouldn't trust a person deeply in debt to tell me the truth.
The final thing is how close we are to demand (which continues to go, albeit more slowly, in recessions) and production. Back in 86 in a 60mbbl/day market the Saudis could turn on the taps and produce 10mbbls (an excess of 8mbbls), today they struggle to produce the same, and the overhand (actual and potential with Iran) is 2mbbls.
It's a market with potential for geopolitical shocks.

Kelly B. on April 11 2016 said:

I had to read Mr. Gartman's statement three times about the "capped wells" before I realized what a barrelful of BS he was dishing out. What oil company on this planet would go to the expense of leasing land, thumping, fracking, drilling, and finishing each well just to cap them when the price of a barrel is low?!! ???????????? Sorry. I felt a big belly laugh coming on and I had to let it happen.
Anyway, thank you Mr. Beago for writing this article. And I hope your correct on the numbers. I would love to see June at $80 give or take for a barrel of oil. ????????

David Vanderwood on April 13 2016 said:

Great article. Is there an error in the Eagle Ford drilling example that says 42 rigs are drilling and 38 are needed to replace declines...?

Ernest P. on June 08 2016 said:

At this time most oil price analysts start to incline to an opinion that the next period of low oil prices comes to its close. You see, global oil demand is rising more slowly than it has been before, but it is rising all the same. In 2014 it increased by about 700,000 barrels a day. In 2015 it was 1,2 million barrels a day. In April of this year it has already risen by almost 2 million barrels per day. And by 2040, says the International Energy Agency, a group representing Western consumers, global consumption will probably reached about 104 million barrels a day, a jump in demand that would require adding another Saudi Arabia and Iran to world supply!
In the meantime, the world's economy starts to recover, helped along by cheaper oil, too, and the pace of demand will pick up again, which always results in oil prices' boom.

A Hockings on September 05 2016 said:

I don't suppose anyone here has noticed we reached 1% global solar last year (2015)?
I don't suppose anyone has looked at the predictions for solar of 2% by 2017 and 4% by 2019?
I guess no one has noticed that next year (2017) there will be 3 affordable 200+ mile Electric cars for sale?
The oil price will now never recover, not for any length of time.
Huge paradigm shift coming. Most haven't noticed...... yet!
@Ernest P. - Oil in 2040? Really? The only thing oil will be used for then is aviation and possibly plastics. The world will be running entirely on renewables and ALL vehicles will be electric way before 2040.